The Bank of England has said the UK may already be midway into a recession, with the economy on course to shrink in the current quarter, but it still hiked interest rates, albeit by less than some expected, as a deep recession may be avoided.
As well as hiking interest rates to 2.25%, their highest level since the 2008 financial crisis, the Bank's Monetary Policy Committee (MPC) cut its forecast for inflation and for economic growth.
The BoE now sees inflation peaking at "just under 11%" in October, down from its previous prediction of 13.3%, which was made before the government's moves to freeze energy prices for households and businesses.
The MPC also predicted that the consumer price index (CPI) is likely to stay above 10% for a few months before falling lower.
Gross domestic product (GDP) is also now expected to decline 0.1% for the current quarter, which represents a switch from the previous estimate that there would be growth between July and September.
Following a similar contraction in the second quarter, once this is confirmed it would mean the UK is technically in a recession, which is classified as two consecutive quarters of negative growth.
The statement from the MPC made it clear that extra government spending, for which more details will emerge in the mini-Budget on Friday, will lead to higher medium-term inflation, as it is expected to dramatically lower the risk of a deep recession.
Minutes from the latest MPC meeting also highlighted that the government’s freezing of energy prices reduces the risk that inflation expectations become 'de-anchored'.
The MPC’s decision to increase rates by half a percent rather than mirror other central banks with a 75 basis-point hike, "provides reassurance that it is focused on the outlook for CPI inflation – which has improved since it last met – and evidence of emerging slack in the economy, rather than with arbitrarily keeping up with the Joneses", said economist Samuel Tombs at Pantheon Macroeconomics.
With the MPC acknowledging that the energy price guarantee meant that demand in the medium-term would be higher than it thought at the time of its August meeting, Tombs noted that the committee "was forecasting a deep recession and an 6.5% unemployment rate at the end of its forecast; it doesn’t need to respond to a better medium-term outlook with further rate hikes".
Victoria Scholar, head of investment at Interactive Investor, said the "timid increase" is unlikely to stem the slide in the pound "but may avoid inadvertently inducing unnecessary pain for the economy, which is already grappling with slowing demand and deteriorating confidence".
Reading through the statement and the minutes, ING economist James Smith said it "is quite remarkable how little the pound featured".
He noted: "Businesses are concerned that the weak pound is adding to their input costs. But the Bank had very little to say on sterling beyond that it had fallen 4.5% since its August meeting. The lack of comment probably reflects the realpolitik of linking sterling weakness to growing fiscal concerns in the UK."
Smith added: "Concerns over unfunded government giveaways and debt sustainability challenges could well see the pound continue to underperform this year ... And don’t expect UK authorities to emulate their Japanese counterparts by trying to support the pound with FX intervention. The UK doesn’t have sufficient FX reserves for that."